R. Christopher Whalen
Aug 27, 20219 min
August 27, 2021 | In this issue of The Institutional Risk Analyst, we put two of our favorite banks, U.S. Bancorp (NYSE:USB) and PNC Financial (NYSE:PNC) in a head-to-head contest. Just for end-of-summertime fun, we toss in Truist Financial (NYSE:TFC), another player in the half-trillion category. These three super regional banks, which have escaped the regulatory coma imposed upon the top four zombie dance queens – JPM, WFC, C, and BAC -- hold great value creation potential. But which is likely to realize this potential? Subscribers to The IRA Premium Service read on to find out.
The fifth largest US money center, USB is based in Minneapolis and is a long-time favorite of The Institutional Risk Analyst with strong funding and revenue diversity. PNC is now of comparable size to USB and has a distinctly different business model that is migrating away from institutional business and toward greater retail exposure. TFC, which is the combination of BB&T and SunTrust, is also a contender. BB&T was always an industry leader in terms of financial performance and stability, SunTrust less so – much less. The combination has yet to regain the historical performance levels of BB&T.
Quantitative Factors
In 2009, other US banks were charging off vast percentages of loan portfolios, BB&T took its sweet time, quarters more time in fact, and thereby improved the bank’s default resolutions. The fact that the bank had the capital and, more important, the income to deal with credit expenses years after 2009 enabled BB&T to emerge from the crisis stronger. This operational strength, however, is not visible in the combined bank’s efficiency ratio, as shown in the first chart below.
Source: FFIEC, EDGAR
The chart shows the standardized measures for efficiency from the FFIEC through Q1 2021 and then the GAAP disclosure for Q2 2021. The regulatory definition of efficiency is: Overhead expenses / Net Interest Income + non-interest income. Under GAAP, however, issuers may adjust such measures, as in the case of TFC, which shows GAAP and “adjusted” efficiency in its earnings supplement.
Looking at the history for our three banks and Peer Group 1, which represents the simple average of the 133 US banks above $10 billion in total assets, the clear leader is USB followed by PNC and then TFC. TFC’s GAAP efficiency was 71% in Q2 2021, but was 56% on an adjusted basis after deducting a $200 million charitable donation and, of course, newly discovered merger expenses related to severance. Surprise!
To us, the GAAP number is the correct measure of bank management at TFC. TFC often tracks wide of Peer Group 1 in terms of operating efficiency, which is a troubling metric for a large bank. Most of the top 25 US banks have efficiency ratios in the mid-50s on a GAAP basis. TFC has a long way to go.
Turning to credit, again USB leads the group, but in terms of the higher net credit losses reported by the bank vs PNC or TFC. Like its larger peers, USB has higher credit expense vs average assets than do its smaller peers and the average for Peer Group 1, which is dominated by smaller banks.
Source: FFIEC
Most US banks have seen credit losses moderate even during the period of stress caused by COVID in 2020. In Q2 2021, for example, USB reported a net loss rate of just 25bp vs 30bp in Q1 2021. PNC reported net charge-offs of 48bp in Q2 2021, up from 25bp in Q1 2021 and a three-year high.
Of note, commercial losses rose sharply at PNC while consumer charge-offs fell. Net losses at TFC are generally running above both PNC and USB, suggesting that the mediocrity of SunTrust is still a drag on the combined bank’s performance. And note please that net losses for Peer Group 1 are running at half the rate for the top-ten large banks.
Next, we turn to loan pricing, one of the most important contributors to bank earnings and also an important operational indicator. Under the quantitative easing from the FOMC, bank earnings have been under considerable pressure as margins have been squeezed and credit spreads have been under intense pressure. PNC, for example, reported a net-interest margin (NIM) of just 2.29% in Q2 2021, an interesting benchmark as you consider the historical gross loan spreads below.
Source: FFIEC
If you figure that PNC’s gross yield on its loan book will be about 3% or a bit higher in Q2 2021, the 2.4% NIM PNC reports on its loan book in its GAAP disclosure is in the right ballpark. Low funding and credit costs make all of this work, but PNC and other US banks have little in the way of net revenue should credit expenses and/or funding costs start to rise. Indeed, the average for Peer Group 1 outperforms the three large banks in this report by a significant margin, suggesting once again that smaller banks have more loan pricing power.
The table below shows the pricing of the assets and liabilities on PNC's balance sheet and the components of NIM. This table, which most investors never see, shows just how difficult it is today for banks to generate asset returns. And the best returns by a wide margin come from consumer loans.
Source: EDGAR
After credit losses and loan pricing, we look at the cost of funds as the other leg of the stool in terms of the operations of a bank. As FDIC noted in its Q1 Quarterly Banking Profile: “The average yield on earning assets declined 1.1 percentage points from the year-ago quarter to 2.76 percent, while the average cost of funding earning assets declined 54 basis points to 0.20 percent, both of which are record lows.” Note that the total cost of funds for PNC in Q2 2021 was just 16bp.
Source: FFIEC
At the end of Q1 2021, PNC had the lowest cost of funds in our sample group, showing that large banks do have superior access to liquidity. The average for Peer Group 1 was just under 30bp at the end of March while our three subjects were below 20bp in terms of interest expense vs average assets.
Notice that USB and Peer Group 1 move around the least, while PNC and TFC have seen more relative volatility in terms of funding costs. Since Q4 last year, both PNC and TFC have pushed down funding costs dramatically so that they are just behind JPMorgan (NYSE:JPM) and the other top money center banks, which basically lend money to themselves sub-15bps.
Finally, we come to the last and most important quantitative factor, namely profitability. Notice we never talk about capital in this analysis, because ultimately it is the return on assets that matters for most banks. Non-interest revenue is also important, but providing priced services to customers is a very different business than lending and investing bank depositor funds, especially when the FOMC is aggressively manipulating the interest rate market.
Source: FFIEC
The sharp drop in bank income in 2020 was caused by the fear of a credit crisis due to COVID. In fact, there was no appreciable credit crisis for banks in 2020, but the United States did careen off the rails in terms of fiscal spending. The rebound in bank earnings was due to the recapture of loss provisions back into income in Q4 2020, and Q1 and Q2 2021, a process which is largely complete. Going forward in 2021 and beyond, bank results are likely to be dominated by the FOMC and the shape of the yield curve.
Qualitative Factors
When you look at our three bank subjects, each has a different business model and area of market focus and, as a result, a different funding profile and asset mix. Let’s summarize the three bank’s profiles:
U.S. Bancorp
USB has one of the most balanced business models of any large bank with more than 40% of revenue coming from non-interest revenue business lines. Only 53% of the bank’s assets are loaned out, meaning that the bank has excess deposit liquidity to the tune of $125 billion or roughly equal to the bank’s non-interest-bearing deposits. USB made almost $1 billion in Q2 2021 from its payments business and has become an island of liquidity serving national customers. This internal liquidity is one of the more important attributes of a money center bank. The table below from the USB Q2 2021 earnings presentation shows the components of non-interest income.
In July, USB announced the acquisition of PFM Asset Management LLC, which will operate under its subsidiary, U.S. Bancorp Asset Management. The total AUM of USB’s asset management business is less than half a trillion dollars. In January 2021, USB acquired the debt servicing and securities custody services portfolio of MUFG Union Bank, an addition that continues to build its institutional business.
USB’s acquisition of State Farm Bank’s deposits and credit card loans in March 2020 marked the first M&A deal for USB involving a bank or a deposit portfolio in about six years. All of these acquisitions, however, are additive and are unlikely to change the basic business model or asset size of USB, which has remained around $500 billion in total assets for many years.
PNC Financial
PNC also has a business model that is different from the typical commercial lender with three reportable business segments: Retail Banking, Corporate & Institutional Banking, and Asset Management. The bank’s loan book is less than 50% of total assets, but the nature of the business is changing with the sale of PNC’s stake in Black Rock Inc. (NYSE:BLK).
The recent acquisition by PNC of the US assets of Banco Bilbao Vizcaya Argentaria, S.A. (NYSE:BBVA) adds more than 600 retail branches in Texas, Alabama, Arizona, California, Florida, Colorado and New Mexico. It remains to be seen whether this collection of disparate, under-performing assets will deliver higher returns for PNC than they did for BBVA.
Truist Financial Corp
Of the three banks covered in this analysis, TFC is the most conventional in terms of its business model. TFC remains primiarly a commercial lender, but consumer balances now are nearly half of total loans. Of note, TFC's loan book shrank $6 billion or 2.1% sequentially in Q2 2021, but deposits continued to grow due to "continued government stimulus," TFC reports. The bank's loans-to-deposits ratio was 73% based on average balances or 20 percentage points higher than USB or PNC.
The bank’s recent acquisitions, including Colonial Bank from the FDIC (2009), Susquehanna (2015) and SunTrust (2019), confirm this conventional retail bank model, but these transactions have also distorted the bank’s financial reporting under GAAP.
TFC management has spent a lot of time placating various political constituencies in order to gain approval of the SunTrust transaction, which cost shareholder almost $600 million in pretax expenses just in 2021. The bank’s financial performance has suffered accordingly. Time spent on “investments in our communities” and ESG are hurting shareholder returns. Until TFC management refocuses its attention on asset and equity returns, as was traditionally the priority with BB&T, we look for the bank to continue to underperform its asset peers and Peer Group 1.
The Bottom Line
We continue to be fascinated by the evolution of PNC into a broader, retail-focused business, but for now USB get’s our vote in terms of business model and overall financial performance. While PNC’s earnings were up in the first half of 2021 more than the other banks in our group and even more than all of Peer Group 1, the release of credit loss provisions played a big role in this performance. As the year progresses, we’ll be interested to see how the run-rate results for PNC and other banks look once the effects of COVID have run out of the system.
“PNC’s promise seems unlimited at the moment,” writes our friend Dick Bove. “Its recent acquisition of BBVA USA is creating multiple opportunities for the company in both products and geographies. The bank must now assimilate this bank and deliver on its earnings promise. The stock’s valuation suggests that investors expect this.”
We agree and more, we wonder if the move by PNC away from an institutional focus and toward more of a retail bank is a good choice. As the chart below suggests, PNC has outperformed USB and TFC during 2021, but has underperformed the bellwether Invesco KBW Bank ETF. Investor expectations for PNC are, in our view, inflated beyond the possible benefits of an expanded retail strategy. Thus for our money, USB with its stubborn focus on a strong institutional business remains the best performer in the half trillion total asset category.
Disclosures: NLY, CVX, NVDA, WMB, BACPRA, USBPRM, WFCPRZ, WFCPRQ, CPRN, WPLCF
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